Belgian Credit Melancholy

Last week's disappearance of the bid for Belgian government bonds was remarkable in its swiftness and brutality. Among the numerous trigger events were rumors that the Belgian government finds itself unable to stem its share of the Dexia bailout. As a reminder, the EBA stress test in July designated Dexia as the 'best capitalized bank in the euro area' with an assessed core tier one capital ratio of 12.1% and 10.4% under the so-called 'adverse scenario'. The adverse scenario turned out to be rather more adverse than anticipated, reportedly due to an interest rate hedge tied to German bunds going awry. The EBA's report on Dexia can be seen here (pdf).

Belgium was supposed to provide € 4 billion in cold hard cash plus € 55 billion in credit guarantees (the latter is obviously a fantasy). In spite of official denials, there is apparently a 'wrangle' over the bailout going on between Belgium and France, based on the latter's lower funding costs.

Belgium is leaning on France to pay more into emergency support for failed lender Dexia, newspapers reported, spooking investors who thought a 90 billion euro ($120 billion) rescue deal only needed rubber stamping.

The countries are wrangling about short-term funding guarantees meant to wean Dexia's "bad bank" off emergency liquidity and allow it to re-enter financial markets, two Belgian newspapers reported.

"Belgium wanted Paris to guarantee more than had been agreed so far, because France can fund itself at a cheaper rate than our country," Belgian daily De Tijd said, following a similar report in De Standaard. The newspaper did not name its sources.

Both countries on Wednesday denied that the restructuring plan for Dexia was being renegotiated, with Belgian Finance Minister Didier Reynders saying he hoped to reach an agreement with the European Commission in the coming days.

In October, Dexia secured state guarantees from the two countries and Luxembourg for up to 90 billion euros of borrowings over the next 10 years, but talks on the fine print are showing little progress, De Tijd said.

As long as there is no final agreement, Dexia remains dependent on expensive emergency liquidity provided by central banks of about 30-40 billion euros in so-called Emergency Liquidity Assistance (ELA), De Tijd said.“

The countries want to get Dexia out of ELA and issue government guarantees instead, ahead of closing a final deal on the 90 billion euro package. The effort is closely overseen by the European Union, according to De Tijd.

They had agreed to share the burden for the interim guarantees in the same way as the October deal, with 60.5 percent falling to Belgium, 36.5 percent to France and 3 percent to Luxembourg.

"France struck a very good deal on Dexia … It would not be surprising that some people within the Belgian apparatus might feel uncomfortable with this," a banker familiar with the rescue of Dexia said. "Re-opening negotiations would be like opening Pandora's box; it could be endless and very dangerous for Dexia's stability," the banker said.

(emphasis added)

The trusty ELA, first employed by Ireland and later Greece, is a sort of last resort financing option involving central bank financing on the basis of a bank-issued IOU (as opposed to the normal discounting of securities held by the bank). If France ends up increasing its exposure to the rescue, it would be yet another potential blow to its coveted AAA rating.

Another trigger event was the failure to form a government, but worse than that, the failure to pass a budget. All of this led to a credit rating cut by S&P late last week:

„Belgium's credit rating was cut one step to AA by Standard & Poor's, which said bank guarantees, lack of policy consensus and slowing growth will make it difficult to reduce the euro region's fifth-highest debt load.

The rating was lowered from AA+, with a negative outlook, London-based S&P said yesterday in a statement. The action by S&P is the first downgrade for Belgium in almost 13 years and puts its credit ranking on a par with the S&P local-currency ratings of the Czech Republic, Kuwait and Chile.

Belgium's borrowing costs have surged to the highest level in 11 years in the past two months after the nation's government agreed to buy Dexia SA's Belgian bank unit and guarantee part of the crisis-hit lender's liabilities for 10 years. Investors continued a selloff in Belgian bonds after six-party coalition talks ran aground this week as Liberals and Socialists clashed over how to cut the budget deficit.

"One cannot ignore the current political crisis that Belgium is facing, but apart from this, this rating cut also illustrates how banking-sector issues can reverberate on the sovereign," said Thomas Costerg, an economist at Standard Chartered Bank in London. "The question is whether other European countries might follow, given rising tensions throughout the banking sector."

(emphasis added)

You bet that the banking troubles redound on sovereigns and vice versa – it has become a vicious cycle. The credit rating agencies have little choice but to follow suit.

EFSF weighted euro area rating by agency and average (unfortunately no higher quality image could be obtained, but the point hopefully comes across even so) – click for better resolution.

The rating cut has apparently galvanized the squabbling political factions in Brussels as they have now passed a budget over the weekend. Het Beland van Limburg meanwhile reported an interesting remark by Belgium's central bank governor Luc Coene:

„Belgium’s political factions reached a deal to reduce the leaderless country’s budget deficit, bringing it closer to forming a government after 531 days of post-election brinksmanship.

Elio Di Rupo, president of the French-speaking Socialist Party who has led coalition negotiations between six of the country’s political parties, thrashed out the accord after all- night talks. King Albert II today asked him to form a government after tensions between the Dutch-speaking north and French- speaking south fueled speculation the country could break up.

Belgium’s rating was yesterday cut one step to AA by S&P, which said the cost of bailing out Dexia SA, a lack of policy consensus and slowing growth will make it difficult to reduce the euro region’s fifth-highest debt load. Caretaker Prime Minister Yves Leterme had called for a deal between the six parties involved before Nov. 28, when Belgium plans to raise as much as 2 billion euros ($2.7 billion) from a bond offering.

“It’s the markets that made them finally wake up,” Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels, said in a phone interview. “It’s good that the markets did this, because no one else managed to convince them — not the electorate.” The “main stumbling block to forming a government” has now been removed, he said.

Belgium faced sanctions from the European Union for failing to tackle the shortfall in its public finances. EU Economic and Monetary Affairs Commissioner Olli Rehn reiterated last week that Belgium must take action to meet that goal.

Central bank governor Luc Coene today urged euro-member governments to take action to restore financial markets’ confidence in the public finances. After that, the European Central Bank and its Belgian counterpart can take steps to restore the functioning of government bond-markets, he told Het Belang Van Limburg.“

(emphasis added)

Belgium's bond offering on Monday is one the many 'event risk' moments the euro area will face this week. Meanwhile, Coene's remark appears to indicate that once the ECB is satisfied that the groundwork for the enforcement of budget discipline has been laid, it will 'take steps to restore the functioning of government bond markets'. Would these be the very steps it is allegedly prevented from taking by statute? Some are arguing that the ECB could now use a number of new pretexts for justifying more forceful intervention: firstly, it could argue that it needs to extend its efforts to 'ensure the transmission of monetary policy is working properly'. Secondly, it could argue that it now needs to combat 'growing deflation risks'. More on the ECB further below, but in the meantime it should be noted that the political gamble the ECB and Germany are engaging in is beginning to bear fruit, as the sudden budget agreement in Belgium shows. Allowing the markets to exert pressure is a strategy that is working, but there is considerable risk attached to it.

Belgium's 10 year government bond yield as of Friday's close. From 4.79% on Monday to 5.85% on Friday – that does look like a wake-up call. It's a right rotzooitje. Maybe they should send in Jean-Claude van Damme to beat some sense into bond traders – click for better resolution.

The leader of Belgium's caretaker government, Yves Leterme, felt motivated to invite the citizenry to take some of the coming debt offerings off the government's hands. One feels almost reminded of war bond propaganda.

„Belgium's prime minister Yves Leterme has called on savers to buy their country's debt. It's something usually left to the finance ministry, which makes a low key request every three months when there is a bond sale targeted at individuals.

So there was an air of desperation this week when Leterme felt compelled to become marketing director for the exchequer, making the call for public funds from his seat in parliament and later in TV interviews. He said: "Given the difficulties on the financial markets, we want to call more on the savings capacity of Belgians to finance the debt."

Belgium is offering savers 4% interest on a five-year public bond. That compares with a yield of around 5% demanded by institutional investors on Thursday for a 5-year benchmark bond. More importantly, the 10-year bond yield is nearing the all-important 6% threshold, which, in most cases, is the point when private investors turn away.

In this context a 4% bond is a cheap way for the government to borrow. But compared to Britain's 2.3%, it is extremely expensive. Is Belgium in trouble? As the Churchill dog says in TV ads for the insurer, "ohh yess".

(emphasis added)

Yves Leterme, smiling – sort of.

(Photo credit: the Guardian)

Scene at the Place de l’Hôtel de Ville in Brussels in September 1830, on occasion of the Belgian revolution (painting by Gustave Wappers). It was all for nothing, you're going to be submerged in the EUSSR now.

(Image via Wikimedia Commons)

If Belgium were the only country coming to market this week the problem may be fairly negligible, but this week will see the biggest sovereign debt rollovers in the euro area for the remainder of the year, with Italy and Spain also conducting sizable auctions. Italy will be a major focus.

Italian Job

Job, confident of his own innocence, maintains that his suffering is unjustified as he has not sinned, and that there is no reason for God to punish him thus.

Late last week another Italian bond auction went haywire, in the sense that interest rates spiked to yet another new high, with the yield curve inverting further. Readers may recall that a yield curve inversion during a time of extremely low administered central bank rates signifies a complete loss of trust by creditors. It is usually the first step in what eventually becomes an unstoppable spiral of rising rates further impinging on the confidence of lenders that the debt can be sustained, which in turn pushes rates even higher, and so forth. Interestingly, Italy's public debt trajectory appears fundamentally sounder or at least not worse than that of many nations the debt of which the market is not treating with comparable disdain. As Unicredit noted in a recent research report, even the much-derided Berlusconi government has achieved a considerable amount of fiscal tightening. The decisive fact may be that Italian government bonds make up such a large proportion of euro area bank assets. Since the banks are deleveraging, there is enormous pressure as holdings of Italian bonds are evidently among those being shed (the recent positive market reaction to earnings reports by euro area banks that had cut down on their holdings of Italian government debt only reinforces this trend).

In other words, neither the relative position of Italy's fiscal situation in the euro area firmament nor the installation of the new 'technocratic' government led by Mario Monti have been able to calm the markets. Indirectly this tells us quite a bit about public debt sustainability in general.

Bond yields on short-term Italian debt rose above 8 per cent on Friday as Rome was forced to pay euro-era high interest rates in what analysts called an “awful” auction.

A peak of 8.13 per cent was reached on three-year bonds, according to Reuters data, as Italian debt traded deeper into territory associated with bail-outs of Greece, Portugal and Ireland in the past 18 months. Italy raised its targeted €10bn in an auction of two-year bonds and six-month bills but at sharply higher yields.

“Rates have skyrocketed. It’s simply not sustainable in the long run,” said Marc Ostwald, strategist at Monument Securities in London.

Investors demanded a yield of 7.81 per cent for the two-year bond, up from 4.63 per cent last month. The six-month bills saw yields of 6.50 per cent, up from 3.54 per cent. That was significantly higher than Greece paid for six-month money earlier this month when it issued bills at 4.89 per cent. That means both Rome and Madrid have paid more than Athens for short-term debt this week.“

(emphasis added)

On Monday and Tuesday, Italy is scheduled to auction between € 7 to € 9 billion, the bulk of the € 20 billion in euro area bond auctions expected for the week (Spain is on deck for € 4billion, France for € 6 to 7 billion).

Considering the funding stresses faced by European banks, who is going to buy all this issuance?

The Euro FRA-OIS spread (or three month forward Euribor-EONIA spread), the euro area equivalent of the USD FRA-OIS spread, a proxy for liquidity stress in interbank funding markets. It reflects perceptions of growing counterparty risk. Similarly, euro basis swaps indicate that dollar funding stresses continue to worsen (however, there are still only two banks borrowing about 550 million dollars each via the Fed-ECB swap lines. There is a stigma attached to using this funding source, but it's a good bet that the ECB may consider lowering the rate it charges – currently the Federal Funds rate plus 100 basis points). For more information on € FRA-OIS and related concepts see the first addendum – click for better resolution.

The big danger is of course a failed auction. There have already been mutterings from Italian primary dealers that they can no longer support the market.

„The primary dealers are finding it hard because the banks aren't making money and the tail risks are huge, volatility is bad … All this points toward failed auctions," said a senior source at a primary dealer, who asked not to be named.“

A similar complaint was raised by Portuguese banks shortly before Portugal was forced to apply for a bailout from the EFSF, so this is yet another ominous development.

Italy's 10 year bond yield ends the week at 7.26% – above the level commonly regarded as the 'point of no return' for euro area sovereigns – click for better resolution.

Italy's yield curve inversion (10 year to 2 year yield) steepens further, ending the week at just over 77 basis points – click for better resolution.

Over the weekend, Italian newspaper La Stampa launched a rumor that the IMF is preparing to launch a €600 billion ($794 bn., approx.) bailout for Italy. This sounds unlikely as the amount mentioned exceeds the IMF's total lending capacity by almost two times – alas, it could be done if the ECB were to lend money to the IMF (this is one of the ideas we suggested would possibly be explored, as it could be done without violating the ECB's statutes). However, at this stage this is nothing but a rumor – albeit one that has sent the euro higher in Asian trading this morning. Note as an aside that Germany has – of course – already 'shot down the idea' last week. According to Reuters:

„One source with knowledge of the matter said contacts between the International Monetary Fund and Rome had intensified in recent days as concern has grown that German opposition to an expanded role for the European Central Bank could leave Italy without a financial backstop if one were needed.

The source said it was unclear what form of support could be offered, such as a traditional standby arrangement or a precautionary credit line, if a market selloff Monday forced immediate action. The IMF inspection team is expected to visit Rome in the coming days but no date has been announced.

An unsourced report in Italian daily La Stampa said up to 600 billion euros could be made available at a rate of between 4-5 percent to give Italy breathing space for 18 months. Such a sum would be beyond the IMF's current capacity and would need new measures such as the issue of new special drawing rights (SDRs) or intervention by the ECB, it said. The Fund's total lending capacity is currently around $400 billion.

The IMF declined to comment on any moves to provide financial support, and official sources in Rome said they were unaware of any request for assistance from Italy, which has over 185 billion euros of bonds falling due between December and the end of April.“

It is impossible to say what will be done if one of the scheduled bond auctions indeed fails, but it is a good bet that no-one wants to see Italy go down the drain above which it is currently swirling. The big problem is of course the reciprocity between the sovereign debt crisis and the banking system's liquidity/solvency crisis (depending on the bank it is one or the other). With nearly € 2 trillion in Italian government debt outstanding, of which an estimated € 1.2 trillion is held by European financial institutions, this has clearly become a risk of systemic proportions. Mario Monti meanwhile is expected to unveil his new austerity package on December 5 – after the upcoming debt auctions.

Should the Italian debtberg implode, we would propose to use the moment of silence that is no doubt going to follow in the wake of the event to play Luigi Nono's Venice-inspired „ … sofferte onde serene … “, so to speak epitaph-wise.

The Centralizers Seize The Opportunity

As we noted last week, Germany – the euro-area's biggest economy and paymaster – seems to play a game in concert with the ECB that aims at emasculating the EU's subsidiarity concept in order to enforce fiscal discipline. For a long time the 'tax hamonizers' had to acquiesce to a system of tax and regulatory competition (the latter has been leveled in large part by Brussels already) that allowed citizens and corporations to 'vote with their feet'.

The aim of tax harmonization is of course to bring taxes across the euro-area up to the highest possible levels. The crisis has created an opportunity to embark on an ambitious centralization scheme that will significantly undermine fiscal sovereignty. Perhaps it is this prospect that has made France back down on its demands regarding ECB intervention. After all, the centralized European socialist super-state is not first and foremost a German idea – it is an idea that has been promoted by prominent French socialists first (e.g. Jaques Delors and Francois Mitterand, to name two). It continues to be a wet dream of the French bureaucratic caste (see also the constant stream of admonishments in this direction by former ECB president Trichet, who was occasionally seen 'communing with Charlemagne' while circling his 1,200 year old marble throne in Aachen).

From Germany's point of view (as a reminder here, Germany has been a hotbed of socialism since the ideology was first thought of – not coincidentally, both Marx and Engels were Germans) the main idea seems to be to ensure that the fiscally conservative don't end up paying for the sins of the profligate. Alas, this argument sounds a bit hollow, considering the fact that Germany itself is in violation of the Maastricht treaty and is anything but 'fiscally conservative'. It merely has had the good luck that its debt has been favored by the markets as the crisis became more acute – which is mainly a function of perceptions about Germany's alleged conservatism (to some extent these perceptions are grounded in reality – diligence and thrift are clearly German character traits) and a function of the size of its economy. The long term fiscal situation of Germany (including 'unfunded liabilities') meanwhile looks actually worse than that of Italy.

Over the weekend, Mrs. Merkel and Mr. Sarkozy seemed to align regarding the way forward – 'closer integration' of the euro area is the new watchword, this is to say, they have now embarked on the road to fiscal union (a.k.a. 'FU' – which is a most apposite acronym from the point of view of taxpayers). Readers may recall that we speculated last week that Sarkozy's promise to refrain from demanding more ECB involvement was actually a step toward creating the preconditions for ECB involvement. The quietude is meant to ensure that the central bank's 'independence' image remains intact. In short, there is likely a quid pro quo, and it basically consists of 'ensuring fiscal discipline' in exchange for the Germany giving the green light for money printing. This theme made it into the German press over the weekend.

„France and Germany are planning a quick new pact on budget discipline that might persuade the European Central Bank to ramp up its government bond purchases, Welt am Sonntag reported on Sunday.

Echoing a Reuters report on Friday from Brussels, the Sunday newspaper said the French and German leaders were prepared to back a deal with other euro countries that might induce the ECB to intervene more forcefully to calm the euro debt crisis.

The newspaper report quoted German government sources as saying that the crisis fighting plan could possibly be announced by German Chancellor Angela Merkel and French President Nicolas Sarkozy in the coming week.

[…]

The European Central Bank should also emerge more as a crisis fighter in the euro zone, Welt am Sonntag wrote, saying that while governments cannot tell the independent ECB what to do, the expectations are clear.

"Based upon these measures, there should be a majority within the ECB for a stronger intervention in capital markets," Welt am Sonntag said. It quotes a central banker as saying: "If the politicians can agree to a comprehensive step, the ECB will jump in and help."

The ECB, which cannot directly finance governments, has been buying Italian and Spanish bonds on the open market since August to try to keep down borrowing costs for the euro zone's third and fourth largest economies.“

[…]

"The European Commission could take on supra-national powers," said one French presidency source, according to the newspaper, saying that Brussels would supervise the decisions of countries at risk of default, provided they request this.

"National parliaments will retain the initiative over the (policy) efforts to be made," one French negotiator told the paper.

The European Commission, the EU executive arm, put forward proposals on Wednesday to grant it intrusive powers of approval of euro zone budgets before they are submitted to national parliaments, which, if approved, would effectively mean ceding some national sovereignty over budgets. Berlin, meanwhile, is pushing to change the European Union treaty so that a country could be sued for breach of EU budget rules in the European Court of Justice.

Le Figaro said there was resistance within Sarkozy's government to allowing France's budgets to be submitted for scrutiny by an "intergovernmental conference" in Brussels, but the president would seek to rally support for this.

A closer fiscal union could eventually pave the way for joint debt issuance for the euro zone, where countries would be liable for each others' debts.

„The pressure of the crisis is allowing things to happen which otherwise wouldn't be possible… the bigger the crisis the greater the need for change."

"The sense that this will bring us much further in the end helps me through the frustrating times.“

(emphasis added)

The frustrating times for the tax cows are probably set to begin concurrently. Who's going to help them?

The sense of urgency was egged on by the recent failure of a German bond auction. Readers may recall that we mentioned that the auction failure as such was probably not a terribly worrisome event, but that the market reaction to it certainly was. Below is a chart from a recent Commerzbank research report that illustrates this nicely:

As can be seen here, this is not the first time a German bond auction failed, but it was the lowest ratio of bids to total issue volume since 2007. Moreover, Commerzbank notes that the coincidence of a high retention rate with a big 'tail' is indeed worth worrying about, as it illustrates the lack of demand. The 'tail' is the difference between the average and the lowest allocated price. Only € 3.664 billion were allocated in view of € 3.889 billion in bids compared to a total issuance volume of € 6 billion – click for better resolution.

A two points sell-off ensued post auction, so one must assume that doubts about German credit quality are now beginning to creep in.

The 10 year German Bund ends the week at 2.26% – a 'safe haven' no longer? – click for better resolution.

A long term chart of the German Bund yield (10 year yield) shows how this yield has tended to behave since the beginning of the euro area debt crisis. It used to go lower whenever the crisis became more acute, and went up when it calmed down again. However, we now have a divergent higher low and rising yield in spite of the additional deterioration elsewhere in the euro area – click for better resolution.

Likely ECB Interventions

There is now a growing consensus that the ECB will lower its administered interest rate again in December, but one wonders to what avail. Similar to the previous rate cut, it is hard to see what difference it will make in view of the sovereign debt crisis and growing funding stress in the banking system.

However, another point that has come up for discussion is that the speed of bank deleveraging may be slowed down if the ECB were to guarantee 'emergency' bank funding for even longer time periods than hitherto. As Reuters reported last week:

„The European Central Bank is looking at extending the term of loans it offers banks to 2 or even 3 years to try to prevent the euro zone crisis precipitating a credit crunch that chokes the bloc's economy, people familiar with the matter say.

The ECB is examining this unprecedented possibility as intensifying fears about the euro zone succumbing to its debt crisis hurt the interbank money market, with banks scaling down the list of peers to which they are ready to lend.

The central bank is looking into offering banks liquidity over a 2-year or even 3-year horizon, the sources said, aiming to free up the increasingly blocked interbank money market and give banks more leeway to buy and hold sovereign bonds.

To date, the longest term it has offered funds is one year.

As the sovereign debt crisis has worsened, the ECB has been coming under increasing pressure to intervene on a larger scale by buying state bonds but is reluctant to make such a commitment. It does, however, have the freedom to lend banks trillions of euros and could use this firepower to indirectly support governments trying to issue debt.

The ECB has flagged the possibility of longer-term loans to banks, sources familiar with the matter told Reuters, in a move that could be aimed at gauging their interest ahead of a launch.

(emphasis added)

Color us convinced that this is indeed going to happen. As we have mentioned previously, this is typical for the slippery slope a central bank-backstopped fractionally reserved banking system eventually creates for policymakers when the point of crisis is reached. The short term 'emergency funding' slowly but surely becomes a permanent feature, as it becomes increasingly evident that not only can it not be withdrawn (as originally planned), but it actually needs to be expanded further if a systemic collapse is to be averted. The difference to 'QE' as employed by the Fed and BoE is really only superficial, in that in theory, these are loans that are temporary in nature as well as involving a plethora of collateral other than sovereign debt.

As it were, the 'collateral problem' of euro area banks isn't resolved yet either. A few months ago, ECB officials still bragged loudly about the large amounts of eligible collateral available to the banks that could be pawned with the ECB, but as we have pointed out, this is no longer true. As the Economist noted last week:

„So far the liquidity of the European Central Bank (ECB) has kept the system alive. Only one large European bank, Dexia, has collapsed because of a funding shortage. Yet what happens if banks run out of collateral to borrow against? Some already seem to scrape the barrel. The boss of UniCredit, an Italian bank, has reportedly asked the ECB to accept a broader range of collateral. And an increasing number of banks are said to conduct what is known as “liquidity swaps”: banks borrow an asset that the ECB accepts as collateral from an insurer or a hedge fund in return for an ineligible asset—plus, of course, a hefty fee.

The risk of all this is two-fold. For one, banks could stop supplying credit. To some extent, this is already happening. Earlier this week Austria’s central bank instructed the country’s banks to limit cross-border lending. And some European banks are not just selling foreign assets to meet capital requirements, but have withdrawn entirely from some markets, such as trade finance and aircraft leasing.

Secondly and more dangerously, as banks are pushed ever closer to their funding limits, one or more may fail—sparking a wider panic. Most bankers think that the ECB would not allow a large bank to fail. But the collapse of Dexia in October after it ran out of cash suggests that the ECB may not provide unlimited liquidity. The falling domino could also be a “shadow” bank that cannot borrow from the ECB.“

(emphasis added)

To put a few numbers on this, Italian banks were recently arguing for a further easing of collateral eligibility rules, which have been loosened several times already. As the 'Business Standard' reports, things are getting quite tight for Italian banks in terms of collateral availability:

„Italian banks have borrowed euro 100 billion from the ECB, and only have enough free collateral to borrow another euro 138 billion, according to the Bank of Italy. That’s little more than the euro 111 billion of wholesale funding they need to refinance by the end of 2012. With wholesale markets effectively closed, the ECB is currently the only game in town.

The collateral famine disproportionately hits smaller banks that are providing credit to individuals and businesses; Italy’s top 111 lenders have euro 92 billion of eligible ECB collateral, while the other 650 hold only euro 46 billion. Part of the disparity is because bigger players have larger stocks of high-quality bonds. But even where the assets being pledged are similar, the ECB’s criteria still favour big banks.

Italian banks’ euro 400 billion of small business loans are a case in point. As the ECB only accepts individual loans greater than euro 500 million, many SME loans aren’t eligible. Meanwhile, for loans to be pledged to the ECB, banks need to have informed the borrower and hold independent verification of the loan’s credit quality. The likes of UniCredit will be able to provide this immediately, but a smaller lender might not. „

(emphasis added)

Here we see another effect of financial crisis playing out: it favors the 'too big to fail' banks at the expense of smaller (and often better run) banks that are the main providers of credit to small businesses. In other words, the credit allocation process is automatically distorted in favor of big business. We have observed similar distortions during the GFC bailout orgy in the US.

Just as fears about the financial health of Italy and Spain have stopped banks lending to some their peers, U.S. funds have also continued to retreat from the region, and Italian and Spanish banks have seen corporate deposits flow out to safer havens.

U.S. money market funds, which are key providers of liquidity to banks and have been pulling back from the euro zone since May, cut their exposure to European banks by a further 9 percent in October, according to ratings agency Fitch.

Bankers said there appeared little chance of wholesale funding markets reopening for euro zone banks this year, and the best that can be hoped is for a return to more normal conditions early in 2012.

"The reality is it's hard to see investors get any confidence (before the end of the year), as the sovereign crisis is out of control. Confidence has disappeared from the banks as they are a conduit for the sovereigns," a senior debt market banker said.“

(emphasis added)

In other words, we can probably expect a few new initiatives to be announced on, or possibly before, December 8 (the next meeting of the ECB's governing council). Meanwhile, another hint that an increase in ECB intervention could be clothed in terms of 'deflation prevention' came from Bank of France governor Christian Noyer, along with broadly formulated promises regarding the ECB's willingness to 'do what is necessary'.

„Noyer said there is room for the ECB to conduct further monetary easing even though it has been taking unconventional policy measures to calm fears about the financial system and support growth.

"We will continue to take necessary steps, although we have been taking necessary steps," he told a news conference here at a financial forum.

He was asked if the ECB will consider buying more government debt and purchasing "eurobonds" that some countries have proposed that all 17 eurozone member states should issue jointly.

"Eurobond buying would be determined by governments in Europe," he said, adding that the governments would have to keep fiscal discipline if they decided to do so.

"We have been injecting liquidity not only to maintain stability of the financial system but also to achieve economic growth," Noyer said. "The ECB is the lender of last resort and we will continue to play the role."

[…]

Financial crises can be extremely violent but at the same time they provide opportunities for reform and progress, he said.

"We have to recognize that the necessary degree of fiscal adjustment is heavily dependent on the level of market confidence," said Noyer. "Second, we should try and delink bank and sovereign risk. In the future, this may call for more structural solutions, with deposit insurance and crisis resolution mechanism firmly established at the euro area level."

As for the role of central banks, Noyer said, "Monetary policy should certainly stick to its mandate and ensure price stability in the medium run.

"In Europe, with financial conditions tighter as a result of the explosion in sovereign spreads, increased uncertainty and loss of confidence — as shown by the fall in most indicators — there are now more downside risks to price stability."

(emphasis added)

This latter point – the alleged 'downside risks to price stability' is what we call the unwrapping of the deflation bogey, which could eventually come in useful to justify whatever is going to be done in terms of ECB intervention. However, Noyer also made a very pointed remark about the 'QE'-addicted central banks in the US and UK – and evidently he realizes why the gold price has been going up.

„Noyer said both markets and some governments seem to consider that the ECB should take a more aggressive stance in buying public debt, but he warned that the central bank must also watch for side effects of unconventional monetary stimulus.

Purchases of significant amounts of government debt by central banks have helped provide markets with an insurance, or even an assurance, against a potential drying up of liquidity, he said.

"In all countries where significant amounts of debt have been purchased by monetary authorities, long-term interest rates have been kept at very low levels, respective [sic,ed.] of their fiscal situation. But this equilibrium could be unstable in a different inflation environment," he said.

"While markets are currently rewarding those countries which liquefy public debt, they seem to be aware of some inflation 'tail risks' and are hedging against these risks through gold, whose prices have reached historical highs."

Hear, hear. Naturally when Noyer speaks of 'inflation' he uses the term in the nowadays quite common Orwellian manner of confusing cause (a rising money supply) with one of its possible effects (rising consumer goods prices). If one defines inflation the way it used to be and should be defined, then there has obviously been plenty of it – in fact, US true money supply inflation over the past three years amounts to a record for the post WW2 era (up more than 52% in less than three years and counting). So yes, investors have been hedging against an as-of-yet unrealized 'tail risk', namely the day when the threshold is crossed where the increase in the demand for money no longer balances or exceeds the additions to its supply, or the point in time when a sufficiently critical mass of economic actors lowers its demand for money (cash balances) due to a recognition that the inflationary policy is here to stay.

So far the central banks have been very effective in managing so-called 'inflation expectations', but this is not necessarily an immutable state of affairs. It can not be ruled out that time period following on the heels of the eventual tipping point will include yet another series of widely 'unexpected' and highly 'non-linear' episodes. Since there is in theory still time to pull back from that particular brink, we cannot say if or when it will happen, but it seems a highly likely outcome if policymakers continue on the path they're on (we frequently dissect Fed board member speeches in order to illustrate this point).

Euro Area Credit Market Charts

Below is our customary collection of CDS prices, bond yields, euro basis swaps and several other charts. Both charts and price scales are color coded (readers should keep the different scales in mind when assessing 4-in-1 charts). Prices are as of Friday's less than hopeful close. Only CDS on Greece saw a significant bout of profit-taking (down a huge 2,300 basis points) in the wake of news that Antonis Samaras has given in and has signed what the EU demanded he sign – opening the way for payment of the next bailout tranche in mid December. This has once again postponed the prospect of a disorderly Greek default for a few more months.

5 year CDS on Portugal, Italy, Greece and Spain – not a lot of movement aside from the sharp decline in CDS on Greece – click for better resolution.

5 year CDS on France, Belgium, Ireland and Japan. CDS on Belgium and France once again hit new highs, and there has been a significant move in CDS on Japan's debt as well. This has happened in the wake of an IMF report on Japan released late last week that has revived doubts about the sustainability of its debtberg – click for better resolution.

5 year CDS on Bulgaria, Croatia, Hungary and Austria – all at new highs, with CDS on Hungary above 600 basis points for the first time since the euro area crisis began. Note that Hungary is once again about to receive IMF assistance – click for better resolution.

5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – CDS on Slovakia have now crossed the 300 basis points level – click for better resolution.

5 year CDS on Romania, Poland, Lithuania and Estonia – the 'new highs club' has just gained two more members – click for better resolution.

5 year CDS on Bahrain, Saudi Arabia, Morocco and Turkey – the Mid East is now home to its own set of troubles, ranging from uprisings in Egypt and Syria to increasing tensions between the West and Iran. This has lately helped to keep the oil price buoyant in spite of growing risk aversion hitting other industrial commodity prices – click for better resolution.

5 year CDS on Germany, the US and the Markit SovX index of CDS on 19 Western European sovereigns. CDS on Germany are almost back at the previous highs, while the SovX is at a new all time closing high. We have said it for many months: it's a bullish chart. CDS on US debt have dipped slightly after the rating agencies confirmed the 'super-committee' failure wouldn't result in further downgrades (for now) – click for better resolution.

Three month, one year and five year euro basis swaps – the plunge deeper into negative territory continues – click for better resolution.

Our proprietary unweighted index of 5 year CDS on eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – yes, it is yet another new all time high. Given the recent 'parabolic' nature of the advance we expect some sort of pullback to begin soon – click for better resolution.

5 year CDS on two big Austrian banks (Erstebank and Raiffeisen) – what else, new highs. Note, since these are indexed to 100 at the beginning of the chart in August, the absolute numbers in basis points are: 405 basis points for Erstebank and 445 basis points for Raiffeisen (for the first time in the euro area debt crisis, both have hit levels above 400 bps. – another deplorable record) – click for better resolution.

10 year government bond yields of Italy, Greece, Portugal and Spain. Here we see the big jump in Portugal's yields following the most recent downgrade. This threatens to become another break-out from a bullish consolidation. The others are all at new highs – click for better resolution.

10 year government bond yield of Austria, the 9 year government bond yield of Ireland, UK Gilts and the Greek 2 year note. Here we can observe how contagion once again spreads. Austrian yields are now in a clearly discernible wave 5 of 3 and up quite a bit over the past two months. Irish yields have been well behaved – up until late last week, when they finally succumbed to the selling frenzy as well. Even 'safe haven' UK gilts saw a little bit of selling on Friday. As we keep saying, these low yields on gilts are based on a dangerous conceit – namely that money printing can 'save' a country mired up to its eyeballs in debt – click for better resolution.

Spain's 10 year government bond yield. They want to sell € 4 billion in debt this week? Good luck – click for better resolution.

A longer term comparison of the yields of Italy, Spain, France and Germany showing the point when they began to diverge (this is ever so slightly dated, given the huge recent moves, i.e. the divergence is currently even more pronounced) – click for better resolution.

5 year CDS on the debt of Australia's 'Big Four' banks, once again higher. We recently had occasion to review the latest data on Australia, and we continue to believe that even at these historically elevated levels these CDS are quite possibly still under-priced. Australia's housing bubble – which has recently begun to deflate, although no definitive statement can as of yet be made that it is bursting – is by some measures among the most egregious ever witnessed anywhere. After the 2008 GFC it was rescued after a brief dip in prices, but it remains to be seen whether the same will hold true of the current dip. Given the dependency of the Australian banks on overseas wholesale funding, a potentially explosive situation is waiting in the wings. – click for better resolution.

China – nominal GDP relative to trend vs. Aggregate credit relative to trend (from a recent Bridgewater report). As so often, we once again observe that more credit growth leads to less economic growth. We would note here that as far as we are aware only Austrian theory provides a satisfactory explanation for this phenomenon – click for better resolution.

China's non-financial and non-central government credit as a percentage of GDP – click for better resolution.

China's credit creation as a percentage of global credit creation. Falling, but still elevated – click for better resolution.

China – total external debt – click for better resolution.

Addendum 1:

For readers not overly familiar with basis swaps and similar short term interest rate derivatives (this is to say interest rate derivatives with maturities of less than one year) we have attached an informative document published by Credit Suisse about a year ago: A Guide to the Front-End and Basis Swaps Markets (pdf).

This is a market that should by now approach about $170 trillion or so in notional size (it was approximately $150 trillion in early 2010, we are extrapolating a bit), so it is a significant portion of the total otc derivatives pie. Said pie keeps growing by leaps and bounds as a chart recently published by Zerohedge shows – at least in terms of notional amounts:

Addendum 2:

Upcoming government debt redemptions across the euro area until 2013, via Morgan Stanley:

2012 promises to be an interesting year for debt rollovers. Unless the recent stresses in sovereign debt recede, we don't see how all these rollovers can be done. Note that especially Italy and Spain have a very much front-loaded schedule – click for better resolution.

Conclusion:

Given the recent extreme moves in these markets and the growing awareness that an even bigger and perhaps uncontainable market dislocation could happen, we expect to see a flurry of activity this week aimed at stemming the bleeding. 'Event risk' is very high and the fear in the markets is palpable (with the curious exception of the stock market, although it has been down six days in a row).

It is difficult to make short term forecasts, but we get a sense that the extraordinary moves we have seen in credit markets last week argue for some sort of pullback or pause, even if it should turn out to be short-lived. Both the ECB and the FOMC will soon congregate and can be expected to aim their money-from-thin-air hosepipes at the perceived problems in one way or another. On the other hand, it would be naïve to totally dismiss the very real risk that the wheels could come off the wagon right away. Many charts of 'risk assets' and 'carry trade' currencies look sick at this point in time, so there is no evidence yet from recent price trends that the crisis will pause, so the hatches should remain firmly battened.

Looks like they are going to attempt to paper over these losses somehow, but of course the market will recognize losses. Look at the USA, which though thought to be through the mess in some fashion by many players, suffers from the losses all the same. The losses in Europe will be taken and I sense Germany will bear the brunt, namely because their trading partners will have enforced austerity against them and thus this will directly affect the German economy and its capacity to pay forward. Vendor financing poor financial risks never works. You might merely look at the effect on Lucent and others in the phone business in 2000. I suspect that once this mess is papered over short term, the market will focus on Japan and China and maybe on the US and UK. But, it won’t be a done deal, print or no print. Gone will be the assets from the bank ledger, with piles of bad debt on the ledger of the ECB. Europe has a shrinking population. So does Japan and soon China, with its 1 child policy.

looking at the 10y german yield, one can just as easily conclude that we are seeing an ABC correction in a downtrend. with yields halving from 3,5% to 1,75% in less than 6 months in 2011, some countertrend move, to relieve the overbought conditions doesn’t seem that strange.
furthermore, I understood that optimism amongst traders was some 95% at the low yields, so we needed some relief there as well. I assume optimism is a bit lower now…but don’t know what the exact number is right now.
lastly, almost everybody has noticed the german yields going up, almost from the first move, accompanied with stories that german finances aren’t that great either (I would agree); and implying that bund yields would go the way of france etc. that seems to be the consensus, and that within a couple of weeks!
given all the above I wouldn’t be surprised if we see bund yields sub 1,5%, or closer to 1% within a couple of months…

You are of course correct that it has been widely recognized and reported, and the wave shape is potentially corrective. Alas, the behavior of Bunds changed already before the failed auction, and there was more to the auction failure than met the eye initially. In principle I agree though that nothing can be said with certainty here. In a scenario where Germany or a core union break away (just as an example), I think Bunds would become like JGBs.